Why There Is Trouble Brewing In Debt Market?

The volatility at the equity markets is a well-known fact and there are phases when it might underperform. During such uncertain times, it is necessary to park some funds in debt products. Debt mutual funds primarily invest in fixed income instruments like government securities, bonds, treasury bills and money market instruments. They are best suited for the investors who do not want to take chances by investing in a highly volatile equity market. But what happens when the debt funds themselves go through myriad uncertainties?

The mutual fund industry’s asset under management (AUM) stood at Rs22.04 lakh crore (trillion) in September, a dip of 12.5 per cent against the AUM of Rs25.20 lakh crore in August. The debt funds for September saw the outflows of   Rs2,44,522 crore.

Rahul Singh, Fund Manager (Fixed Income), LIC Mutual Fund Asset Management, said “Outflow was triggered mostly due to three reasons - default by infrastructure finance company IL&FS, negative interest rate views and liquidity issues in non-banking finance corporation (NBFC) and housing finance sector.

Let’s take a look at how the prevailing scenario is impacting the investors, and what should they do in a volatile time ahead, which is expected to stay for a longer period than anticipated.

Domino Effect

A recent shocking default over asset-liability mismatches at IL&FS led to panic in the Indian financial sector. The investors are worried about its impact on the credit market as well as on other NBFC’s.

Mahendra Kumar Jajoo, Head (Fixed Income), Mirae Asset Global Investments (India), said, “Mutual funds provide the safest and fastest exit of all options and therefore it’s no surprise that panicked investors rushed out of debt mutual funds.”

As per the Association of Mutual Funds in India (Amfi) data, the major outflow has been seen only in the liquid fund category. In September, the liquid fund saw a net outflow of Rs2,11,050 crore.

Many fund managers have attributed the outflow towards the banks and corporates, who redeem units at the end of every quarter to pay advance tax. “Corporates form a major proportion of liquid funds’ AUM and they might have withdrawn partly due to a payment of advance tax and partly due to the fear of making no returns due to default of some papers,” said Raj Mehta, Fund Manager (Debt), PPFAS Mutual Fund. “Hence some of the corporates might have shifted some of their money to relatively safer destinations like bank fixed deposits,” pointed out Mehta.

Also since September 2017, the interest rate cycle in India has reversed with rates moving up sharply. The 10 year Government securities has gone up from 6.65 per cent in September 2017 to 7.98 per cent as on October, 2018. Further, RBI has increased rates by 50 basis points (bsp) in Financial Year 2019.

 Avnish Jain, Head (Fixed Income), Canara Robeco Mutual Fund, said, “These events led to selling by foreign portfolio investors (FPI) who want to limit losses in debt papers as rates went up. Also the ongoing US-China tariff war, rising crude prices and emerging markets sell-off, is adding pressure on the currency. This has led to more outflow as depreciating currency reduces returns for FPIs.”

Investors Bearing  The Brunt

Depending on the average maturity of the fund, investors in debt funds are likely to see subdued returns. Bond yield and prices are inversely related. This means when rates go up, prices of bonds come down and vice-versa. As a result, when rates go up, net asset value (NAV) of a debt fund come down.

 “With the increase in interest rates, there could be some mark to market (MTM) losses in the NAV’s of corporate bond funds and dynamic bond funds categories. Earlier this was seen happening with Amtek Auto, Ballarpur Industries, etc. and it is better not to chase returns in the debt funds,”  explained Mehta.

For the investors who had exposure to IL&FS and have suffered large dips in NAV, as a result, market witnessed huge outflows last month. “Lot of investors have lost money due to IL&FS default and negative MTM impact due to rates moving up and liquidity issues in the NBFC sector,” said Singh. Investors should understand that market risk is always temporary, as compared to the credit risk which is rather permanent by nature.

Some market experts believe that there can also be a short-term pain where the investors don’t earn any return on their liquid funds due to this. By and large, this crisis has not impacted other investors. Jajoo said, “As interest rates have been moving up, most debt funds NAVs were any way generating subdued returns but the impact of credit defaults which have dented the NAV may not recover any time soon. Further adverse impact of this credit default on other NBFC’s may continue to put pressure on funds with high exposure to this category.”

Investors Course Of Action

RBI raised rates by 25 bsp twice during the year while keeping the stance “neutral”, however, it refrained from hiking the rates during its October bi-monthly review meeting and changed the stance to “calibrated tightening” indicating that rates may rise in future. Keeping into account the current situation, many experts feel that stance to calibrated tightening has not made much of a difference to the investors.

Jajoo explained, “Calibrated tightening is a signal to use monetary policy during inflation, targeting and supporting growth, and not for defending the currency. It may have provided some relief and lifted sentiments for now, even as the situation remains challenging, with elevated oil prices and tightening global financial (liquidity) conditions.”

The experts feel that markets have discounted about more 50 bps hike in the interest rates in the last one year as CPI inflation continues to remain in RBI’s medium-term target of four per cent. Jain asserted, “Markets have already gone up sharply in the last one year and seem to have discounted a lot of negatives. While markets are likely to remain volatile on global geo-political scenario and local political sentiments ahead of 2019 general elections, it is recommended that investors use this uncertain period to increase allocation to debt funds.”

Understanding Risk Appetite Is Crucial

Understanding time horizon, risk appetite and need to optimise your investment is crucial so that you get an optimal risk-adjusted return. The lower the risk appetite, the higher should be the allocation towards debt funds. Be aware that it does not mean zero risks but simply lower risk than equity. Also, if some investor needs money in say one or two years, he is better off putting money in debt schemes. Choosing an appropriate debt fund scheme as per your age, income, goal and risk-taking abilities also plays a vital role. These parameters should optimise investors’ investment so that they get an optimal risk-adjusted return. “No one perhaps can suggest anything to those who neither have a well-defined goal/objective or horizon,” said Jajoo.

If investors invest in liquid funds, then on redemption they get principal plus appreciation back in next working day. In case of debt funds and equity funds, the same on redemption comes within two or three days. Mutual funds are convenient since they offer ease of transaction, are transparent and you get to know your portfolio valuation daily. “Investors with asset allocation approach and long-term horizon should continue to stick to the core of their strategy. On the other hand, investors with very short horizon should consider shifting to safer products like liquid funds,” said further Jajoo.  Given the uncertain times, investors are advised not to panic and stay put by focusing on a disciplined approach for long-term.

himali@outlookindia.com